Risk-Factor Portfolios and Financial Stability

Abstract

By utilizing the extreme dependence structure and the conditional probability of joint failure (CPJF) among risk factors, this paper defines a risk-stability index (RSI) that quantifies (i) common distress of risk factors, (ii) distress between specific risk factors, and (iii)
distress to a portfolio related to a specific risk factor. The results show that financial stability is a continuum; that U.S. banks tend to cause the most stress to the global financial system (as defined herein); and that Asian banks show the most persistence of distress. Further, the panel VAR indicates that "leaning against the wind" reduces the (potential) instability of a financial system.